Monday, September 17, 2007

Is Diversification an "illusion"?

Most gurus are usually focused investors, from Warren Buffett to Charlie Munger to Mohnish Pabrai. These three gurus, at least two of them qualify to be named the “deans” of value investing and my personal heroes, all believe in making large bets when the odds are in their favor. Buffett’s purchase of American Express during the “salad oil” scandal of 1963 had him put 40% of Buffett’s Partnership assets into one single asset. Buffett in his speeches to college students is famous for mentioning the card with ONLY 20 punches for their entire investment career. He said that each student or investor should imagine they each are holding a punch card where there’re only 20 opportunities for you to enter into an investment. This will makes one think deeply and seriously to minimize their number of tries although it doesn’t seems to most people that the more they limit their swings, they more they would be able to find themselves holding back their swings in order to wait for the fat pitch. Personally, I think most investors have the misconstrued idea that the more tries they have and the more they try to switch from one boat to another, the higher their chance of beating the market or the general performance – I may be wrong but I think no one has been able to do so consistently or more important, sustainably. If you can ignore the noise when others tell you “swing, you bum!” and think by yourself, you’ll be much better off financially and emotionally.

So every time you make an investment, you punch your card once. It’s difficult to really get 20 wonderful decision in an investment lifetime. But it is possible to get a couple, or even a few. And these few wonderful ideas would make you a very wealthy person.

Buffett did not get rich by jumping ship whenever Wall Street paints a different picture. He got rich mainly because he is 1) objective; 2) focused (both in thoughts and betting when the odds is right); 3) waiting for the fat pitch and betting big when it comes. He is smart for sure but that has probably less to do with his investment success than being objective and logical. There’re many people who are as smart as him in terms of I.Q. But in investing, the most important quality, according to Buffett, is not how much IQ you’ve got, but rather temperament. You can have an IQ of 150 but you can be pauper if you lack the emotion needed in investing (Long Term Capital Management is one prime example). A reasonable amount of intelligence is required but temperament is 90% of it.

So when you restrict yourself to 20 opportunities in investing, it is essentially telling yourself you must not diversify. In Buffett’s words, DIVERSIFICATION is only for people who do not know what they are doing. Well, although I have to admit diversification is on the whole good for people who do not have the prerequisites to proper sustainable investing, then putting money in a diversified mutual funds or ETF is the best investing method. One thing to note for investors who invest in funds that track the market, they cannot and must not expect their returns to be better than what the index or market can perform on the average, or even on a yearly basis for any of the year that they have their money in the fund. Why? Any funds that track the market will always tag along to the market performance, and in any case, investors have to pay haircuts or commissions to the intermediaries. So the return must logically be less than the market performance. But what an investor can do to ensure that his long term result is better than most other investors who similarly have invested in a fund that tracks the market is to find the fund that has the least cost and low turnover rate because cost is the component that caused the fund performance to be below that of the market index.

If you chose to be one who wants to have the fun and experience to be a true investor, then the idea of restricting oneself to 20 opportunities is a big idea. But the important thing here is to be able to recognize those 20 ideas when you see them, and that you do something about them. There’re only few questions an investor should ask themself in order to identify such Twenties. First question is “how long does it takes the management to have to think before they decide to raise prices?” The ability to raise prices coupled with the ability to differentiate yourself in a real way means you can charge a different price and that makes it one-half towards being a great business. Then the next question to ask is “will the business still be around five or 10 years from now?” And if they do, “will their customers be able to get their fixes, services or products from some other different sources?” Essentially, these are questions an investor must ask before investing and the key is to identify firstly, great businesses and then secondly, to purchase a meaningful amount at a fair price, or even better unvalued price. These questions are simple enough but it is actually more in depth which I shall write a little more in my next article.

Charlie Munger, in his speech at USC in 1994 on a Lesson on Elementary, Worldly Wisdom as it relates to Investment Management and Business, said that you wait until you find a mispriced opportunity. The wise ones bet – read invest – only when they get that great opportunity – read fat pitch in Buffett’s words. They bet big when they have that opportunity. The rest of the time they don’t, it’s that simple. Ironically, most people, they find themselves smarter when they try to do more and to have more tries. Later in the same speech he says that “most of Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s a very brilliant man. Warren’s a lot more able than I am and very disciplined…devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying that most of the money came from ten insights.” Right now Berkshire’s top 6 marketable stocks account for 70% of their stock’s portfolio.

Mohnish Pabrai manages Pabrai Investment Funds and, since 1999, has delivered annualized returns of over 28% (net to investors). With a track record like that, he’s worth listening to (at least somewhat because it takes a much longer time in order to be recognized as a great investor). As of March 31, 2007, Pabrai registered 13 holdings in his portfolio. A steel producer, IPSCO, comprises over 18% of his portfolio. In his book, “Few bets, big bets, and infrequent bets,” is the title to Chapter 10.

Now really do we need further analysis to prove all the above? I understand there’ll always be many investors who are “impatient” and want to own “many stocks” or even “jumping from flower to flower.” It is good to have more such, in fact, I hope so because it reduces the pool of serious investors who are of a better grade. But the question to ask is which side do you like to be on. Each person needs to do what suits their personality best. I cannot guarantee you that the stock you buy at 45 times earnings have no chance of going to 70 or 80 but I can tell you the likelihood is against you. The stock that you buy at 45 times earnings that doubles in 6 months might be profitable but you are not practicing value investing. (DISCIPLINE we are talking about here.) The true value investor bets infrequently and on stocks that are “priced” appropriately. Buffett has not, never before, and apparently never will buy any stocks that are priced at 35 times earnings. Walmart, Coke, Gillette, Geico, Johnson and Johnson, Wells Fargo or any of his other holdings that got him the bulk of his wealth were not bought at PE that were 35 or even 25 for the matter. They were purchased when they were “teenagers” (PE in their teens). Pabrai in an interview in early 2007 says that the number one trait a successful investor needs is patience. He even admitted that he is a shameless cloner of Buffett.

One thing to add besides what have been communicated by my heroes, or even Pabrai is the fact that in life, not everyone will feel they’re as much rewarded financially than they’re intellectually. But personally, I think intellectual reward is much gratifying than financial rewards. In most cases, intellectual rewards will lead to financial rewards but not necessarily on the same scale that you feel or expect it to be. Having said that, a person only can have about 3 meals and 24 hours a day, so why the heck does one really need to be rewarded financially way beyond what they really need? Having 2X financially may initially make you jump for joy but not necessarily when you have 3X against 2X. Personally, I think it will be more rewarding and satisfying if the multiple of X, in terms of intellect, increases.

Want to make 28% compounded annually? Well, just be a shameless cloner. We don’t need to be an original thinker or inventor like Einstein or Mozart to be successful. Even Mozart led a miserable life because he overspent his income that is a nuttiness that sometimes accompanies even a smart guy like Mozart. And we can definitely see there’re many smart talented people in the investment community with a streak of nuttiness. After all that have been said, it seems investing is a simple game, although not easy by any means, but by no means is investing a difficult task. Essentially, if you can answer the few answers that are important – most are not – and applying those by finding the few ideas that cause extraordinary results and finally, have the wisdom and discipline to sit on your bum, you’re well on the way to a decent result, although it seems to be a boring one.


fishman said...

I like the idea here of "less swings", partly because it gives me reason to slack a bit ! =P

But I understand that Value investing doesn't mean lazy investing. By right there lots of hardwork and studyinh and research right?

One thing that bothers me is, how do I know that the incoming ball is potential for homerun?

P.S. I'm still waiting for insights to your scenarios!!

Berkshire said...

Hi Fishman,

Less swing does not equates lazy. Less swing means chose your swing well. If you swing at very ball that comes your way, you get a ticket to the minor hall. If you only swing at the fat ball, you get a ticket to the hall of fame.

What investing really needs in my opinion is lots, and lots, and more and more reading and learning. Reading and learning does not mean you have to be actively involved trading in the market. Reading and learning is to pick up the right ideas that work. In an investment lifetime, one will not get more than 20 good ideas. In fact a couple, or a few of it will provide most of the eventual wealth that you probably would not have dreamt of.

Active investing as in keep swinging only strikes me as immature investing and probably not knowing what business he or she is investing in. It definitely makes the broker richer, but it also definitely ensure that such fickle minded investor will not be financially rewarded in a fine manner.

Another thing that I advise is to ignore the daily, monthly, quarterly or even yearly swing in stock prices. The only logical reason why one keeps looking at what the business is doing (for example, securing a new contract, buying a few vessels or so on) and then keep tracking their changes in monthly net-worth by marking their wealth to market appears pretty foolish to me.

If one buys a fine business at a fine price, honestly, you can even stop reading all news about them or even speculate what will be the next move the management will make. Because it doesn't affects the long term viability of the business.

Over time, there're only a handful of fine businesses once you look into universe of stocks that are available.

Wile said...

Thank You so much Berkshire for my sunday afternoon read -- reinforce my believe in value investing. :)

Penny Stock Blog said...

I would like to comment about traders being overly concerned about indexes like the standard and poors five hundred. Why not concentrate your efforts on concenrtated narrow sectors though exchange traded funds.Their are now over fifty single country funds available and maybe over 100 narrow sectors like airlines steel solar so why the concern for the nasdaq or the standard and poor five hunderd each one of these countries and sectors is a index of and by itself. The solar exchange traded fund {TAN} is now down 90% from its high in 2007. If I were an investor or trader. I would simply look for any exchange traded fund or closed end fund that does not use any leverage in their portfolios and start buying after their is a 75% decline from its all time high' and than buy twice as much if that exchange traded fund or closed end fund declines another five percent an 80% decline from its all time high' buy twice as much at a 85% decline from its all time high buy twice as much at a 90% decline from its all time high' and finally buy twice as much at a 95% decline from its all time high. Now I know that some of these funds will not decline 90% from their all time highs maybe not even 80%. Another thing that you might be wondering about I would run out of money If I followed that method right wrong. Example take one hundred thousand dollars. Buy 500 dollars of xyz fund at 25 dollars off 75% from its all time high of 100 dollars. Buy 1000 dollars of xyz at 20 dollars off 80% from its all time high of 100 dollars. Buy 2000 dollars of xyz at 15 dollars off 85% from its all time high of 100 dollars Buy 4000 dollars of xyz at 10 dollars off 90% from its all ltime high and finally Buy 8000 dollars of xyz at 5 dollars off 95% from its all time high for a total of 15500 about 15 percent of total cash assets. I am giving an example here the actual investment amount for an exchange traded fund or closed end fund that you are investing in would be the percentage of cash in the account not the percentage of both equities and cash combined.. The investment percentage for each fund would be based on the cash portion of your total portfolio at any given moment in time simply because the dollar amount of cash in the account would change fairly often, So if you have 40% of your portifolio in cash you would use that as your basis for determining your allocation not the total value of both cash and equities. The idea is to have your biggest positions in the funds that have declined the most and the smallest positions in the funds that have declined the least. Also keep in mind when you buy an exchange traded fund you are buying a basket of stocks so the fund cannot go to zero unlike a stock.Than when any fund has regained three quarters of its value that would be 75 dollars in the case of eyz use a 10% trailing stop loss to protect your gains. Who knows you may sell out of the fund with in 90% of its all time high. And their you have it a simple but brilliant strategy. Also keep in mind that you will have tremendous diversification using this method which would mean you could easily employ some leverage in the form of buying on margin. Even without margin I believe that this could be one of the greastest investment methods of all time you will be almost assured of crushing the performance of the standard and poors five hundred. The.Only thing that could change this outcome would be a great worldwide depression.